How to Think About Corporate Tax Cuts
Corporate tax cuts will put billions of dollars back in the hands of businesses this year. Naturally, people want to know how those businesses will spend it. But the answer doesn’t really matter, at least not for understanding whether the tax cuts were a good idea.
That’s because the economic case for corporate tax cuts has almost nothing to do with what corporations do with the extra cash.
Economists generally recognize that corporate tax cuts have two quite distinct effects.
First, a tax cut increases the incentive to invest. A lower corporate tax rate gives investors in a new factory a larger share of the income that factory generates. And that in turn leads more investment projects to pass the cost-benefit test that tells a company whether it’s worth building the factory in the first place.
This incentive effect drives most economic models of investment, and few economists debate its underlying logic, although there’s considerable debate as to whether it will yield a large or small increase.
Second, a tax cut showers extra cash on companies. That cash largely comes from companies that are suddenly paying a lower tax rate on profits earned from past investments. This windfall has a big effect on the distribution of income, with billions of dollars going to owners of capital at the expense of taxpayers. But few economists believe that this cash transfusion will do much to bolster future investment, because the profitability of a new capital project depends on future revenues and expenses, not on how much cash a company has lying around.
As Alan Viard, an economist at the American Enterprise Institute, has written: “The economic case for corporate tax rate reduction is not based on how companies ‘use’ their tax savings. It is based on how companies change their behavior in order to obtain larger tax savings.”
Yet the early debate about whether the tax cut is working has barely focused on the incentive effect, tracking instead what companies are doing with their cash windfalls.
Mr. Trump boasts that he’s put more money in the hands of corporations and that they are using it to give bonuses to their workers. Many critics counter that the recent spike in stock buybacks shows the money isn’t going to anything useful like financing new investments.
Both of these arguments are beside the point. They’re based on flawed reasoning that says businesses invest only when they’ve got the cash on hand to pay for it.
It’s wrong because companies with profitable investment opportunities can usually find ways to finance them, whether by borrowing from the bank, issuing stock or bonds, or taking on strategic partners. (Cash is especially helpful for smaller companies that find it difficult to borrow, or for projects where outside investors fear being exploited, but these effects are likely to be small.)
The big mistake is to assume that what’s scarce is cash. The reality is that profitable investment opportunities are scarce.
What can we learn from the recent surge in stock buybacks, in which companies buy back their own shares, effectively returning their spare cash to shareholders?
Quite possibly, nothing, as far as the merit of the tax cuts goes. Standard economic theories suggest buybacks would occur whether or not the tax cuts succeed at stimulating investment.
Here’s why. The tax cut showers cash on corporations indiscriminately, not just on those with great investment ideas. Some companies now have extra cash but no ideas to spend it on. For them, the best response is to return the money to shareholders, through higher dividends and stock buybacks.
Whether that money will bolster the economy depends on what shareholders do with these unused funds.
Say the tax bill is a success and it leads companies to find many new investment opportunities. Shareholders will be eager to use their newly-returned funds to finance those companies with the most profitable projects. In this happy version, the buybacks channel money from firms with few profitable investment opportunities to those with better prospects. Investment rises and the economy grows more rapidly.
Alternatively, the tax bill could be a bust, for several possible reasons. Perhaps lower taxes don’t lead companies to invest more. Maybe rising government debt results in higher interest rates, countering the investment incentives created by the new tax code. Whatever the cause, if the tax bill fails to create new investment opportunities, shareholders won’t reinvest their funds.
In either scenario — both when the bill’s proponents are right and when they’re wrong — stock buybacks are common. John Cochrane, a senior fellow at the Hoover Institution, has described the idea that buybacks yield any worthwhile judgment about the efficacy of the tax law as “the buyback fallacy.”
The broader lesson is that it’s worth paying greater attention to what actually happens to investment, and less to cash flows and buybacks.
Finally, what should we make of Mr. Trump’s boasts that his corporate tax cuts are responsible for companies announcing bonuses for their workers?
Kent Smetters — a professor at the University of Pennsylvania’s Wharton School, and a Treasury official in President George W. Bush’s administration — found Mr. Trump’s reasoning unimpressive.
In the short run, giving more money to corporations helps only the owners of corporations. The benefits trickle down to workers over many years, as tax cuts first increase investment, eventually intensifying competition among firms looking for workers to operate newly-purchased machinery and other capital equipment, ultimately raising wages.
Instead, Mr. Smetters suggested that these carefully-timed bonus announcements were a “gratuitous payback for President Trump,” from opportunistic chief executives looking to be seen “patting him on the back.”
Mr. Smetters noted that the incentive to grant pay rises hasn’t risen, but the incentive to make Trump-friendly corporate announcements probably has.
Neither stock buybacks nor bonus announcements say much about whether the tax bill is working. That remains an open question. It’s simply too early to tell.
Justin Wolfers is a professor of economics and public policy at the University of Michigan. Follow him on Twitter: @justinwolfers.